Are You Blindly Saving for the Future? – Forgetting to Analyze the Withdrawal Process During Savings Accumulation

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saving money, savings goal, retirement, retirement planning, IRA, Roth IRA, 401k's, Individual 401k, retirement withdrawals, hardship withdrawals

Since I finished my undergraduate degree in 2008, I have been pretty good at aggressively saving for retirement and the future in general. For the most part, I have been able to do this simply by keeping my expenses low, being fortunate enough to have escaped college with no consumer debt, and also integrating saving in to my everyday life as a hobby (I am a personal finance blogger, after all!).

However, only recently, I realized that I had been doing something wrong all this time. While this mistake isn’t something as serious as say racking up $50,000 worth of credit card debt via overspending, it is still significant and something that needs to be addressed. And, from what I’ve been reading recently, it is one mistake that is made by many young and middle-aged people because of what society has deemed as the “normal” way to invest for the future.

What was I doing wrong? Well, I realized that I have been so focused on saving (input) as much as possible and subsequently investing it with an appropriate strategy/asset allocation (execution), that I hadn’t stopped to consider what ramifications my inputs and execution would have on the withdrawals I will eventually take as a result of investing (output).

Essentially, I have just been working under the assumption that if I save, save, save as much as possible and invest it appropriately, my future and retirement will take care of itself. After all, what more can someone do to prepare financially for the future except for save as much as possible? Nothing, right?

Wrong! By making sure that we not only save as much as we can but also place the savings in to appropriately structured buckets, we can more adequately prepare for the variety of financial situations that life throws our way.



Society’s “Norm” for Investing for Retirement – The Good Ole’ 401k

With the primary collapse of the traditional pension system of retirement income that one received after working for the same company for 30 years, the bulk of the emphasis society places on saving for retirement and the future these days is the traditional 401k.

If you’re like me, you’ve no doubt been taught that if you don’t have any other debt to payoff, have an established emergency fund, and have an adequate amount of liquid cash on hand to meet your predicted short term needs, putting as much money as possible in to a 401k account is absolutely one of the best things that you can do to prepare for the future because you get tax-deferred growth and tax deductions in the current tax year.

Sure, if you’re fairly young like I am and meet income constraints, it is common knowledge that it’s more advantageous to first make sure to fully fund a Roth IRA prior to fully funding a 401k (which I do each year). However, with the current annual contribution limit for IRA’s being $5,500, a Roth IRA alone will likely not be sufficient to fund an extremely comfortable retirement, even if you’ve started early like I did at age 21-22. You will want/need to save more.

So, after exhausting the option of fully funding a Roth IRA, where did I (and I assume a lot of people) end up parking the bulk of their savings for retirement (with the exception of maybe a little bit of money here and there in taxable accounts)? 

You guessed it – the 401k because of society’s emphasis on all of the tax advantages that you get in the present time. 

Problems with “Blindly” Parking a Majority of Your Savings in IRA and 401k Retirement Accounts 

While IRA’s and 401k retirement accounts are a very good way to save money (in my opinion), I have realized recently that they are slightly over-emphasized in the financial planning process.

Sure – they definitely have an important place, but I’ve recently concluded that in order to fully optimize my finances, they cannot be the ONLY main buckets in which I place money saved for long term needs. In addition, I have realized that I should frequently review my financial needs to determine what ramifications are incurred during the withdrawal process if/when a need arises that I need to access my savings.

There are two primary reasons/withdrawal considerations for why it is not a good idea to blindly “save as much as you can” in IRA and 401k accounts:

  • Loss of Access
    • While going through all of the minute details of treatment of withdrawals from retirement plans would likely take a post all by itself, it will suffice to say that savings parked in IRA’s and 401k’s are not very easily accessible. And, easy access to savings is without a doubt, a very powerful thing that I had been underestimating.
    • For example, let’s say that a fictional 22 year old man named Jim contributes $16,500 per year to his company’s 401k. On top of that, he fully funds a Roth IRA with around $5,000 per year. He continues to save vigilantly in this manner for 10 years, at which time, he decides he wants to purchase a condo to rent out as a real estate investment and needs to find some money for a down payment.
    • Since the purchase of rental real estate isn’t a “qualifying” purchase, any money being withdrawn from his 401k would be hit with a 10% penalty and any earnings from his Roth IRA would have this same penalty (his contributions to his Roth IRA can be withdrawn at any time tax and penalty free, an important thing to know!).
    • Essentially, the moral here is that you don’t want to be in a situation where you are surprised because have a lot of net worth, but none of it is liquid/accessible to execute on the endeavors that you want to.
  • The Effect of Taxes
    • Yet another pitfall that I realized I have experienced by blindly saving as much as I can in retirement accounts over the past few years is the effect of taxes on the withdrawal side.
    • Basically, the question here becomes when do you want to pay the income taxes on your savings – now or in the future?
    • With traditional IRA’s and 401k’s, even though you are not taxed in the current year for the money, you will definitely pay a good chunk of income tax on the withdrawals after the money has experienced years of compounding.
      • For example, do you want to pay income taxes on $1000 today or income tax on ~$45,000 after that $1000 has grown at 10% per year in the stock market for 40 years.
    • As I mentioned above, I definitely have realized and am utilizing the Roth IRA as a way to achieve tax free income in retirement (since the contributions are after-tax when they go in).
    • Essentially, I would rather pay the income tax now since I have a very low 20-30% overall tax rate as opposed to later in life when I have more savings compounded and income (and likely the government increases tax rates to deal with health care, Social Security, etc, but that is only speculation).
    • However, after maxing out my Roth IRA, the mistake I made was that I just sort of blindly assumed that there were no other tax-free options worth looking in to that would be better than a traditional 401k because the 401k is generally assumed to be a great thing!
    • Thus, for the past few years, I have been dumping as much as I could in to my employer’s or self-employed 401k accounts.

If you’re like me, you have likely read these access and tax provisions/considerations many times before. 

You know – it’s the stuff that’s in fine print on the account signup forms and/or lumped in to the category in our heads as “boring tax stuff that I don’t have to really need to pay attention to.” For me specifically, what I realized was that even though I was reading these details, they weren’t sticking because I just assumed that it wasn’t a big deal because it would “happen some distant time in the future,” and everything would magically work out since I used the popular 401k! In other words, I was reading the facts, but wasn’t making the connection about what it would be like to LIVE the considerations. This is a huge difference that you want to make sure to be on the right side of! 

Conclusions

As I mentioned above, the point of this post is not to say that IRA’s and 401k’s are evil or bad. They are actually quite good.

However, the key thing to remember is that before you commit to putting any significant amount of money in to one of these buckets now, make sure you acutely understand not only the benefits (which society touts readily), but also the things you will lose in regards to 1) access and 2) taxes on withdrawals 10+ years down the road.

After thinking about these considerations, you may conclude that you’re on track exactly like you need to be. If this is the case, then great! Just keep on saving as much as you can and diverting the funds to your retirement accounts. However, I imagine that most people (including myself) are somewhere in the middle in that we are on track pretty much, but still have some room to improve upon the positioning of our long term savings in buckets that are slightly more accessible (without penalty).

How about you all? In thinking about your current asset distribution, do you feel that you are placing too much, too little, or an appropriate amount of savings in to retirement accounts vs. other vehicles? What would say the %’s are for your assets in retirement vs. non-retirement accounts?

Would you prefer to pay taxes now or when you receive income during retirement?

Share your experiences by commenting below!

    ***Photo courtesy of http://pixabay.com/get/1f6984b99b1d905f282e/1363046890/sign-41432.png

    Comments

    1. I looked into universal life insurance as an investment a while back, but it seemed way too complicated. The policies were complicated. The benefits were complicated. The rules and risks were complicated. I need my life to be a lot simpler than that.
      My recent post Year-End Note

      • Thanks for your comment SB! I have actually been doing a ton of research lately in to permanent life insurance as a savings vehicle. I’ve learned a ton of helpful things. But you’re totally right, it’s very complicated. I should have a post up soon detailing my experiences and ideas!

        Do you have term life insurance?

    2. MyFIJourney says:

      The fatal flaw in your Roth/traditional comparisons is that they assume that all savings are removed at once. If they are removed in portions, then the Roth gets crushed by the traditional due to the effect of marginal tax rates.
      My recent post A Brief Primer on Dividend Growth Stocks Part 1: What are they and how do they make money?

      • Thanks for your comment MyFIJourney! I'm a little confused. Are you talking about removing money during retirement/after age 59.5?

        If so, I was under the impression that Roth IRA withdrawals during retirement are not included in your adjusted gross income calculations, thus preventing your marginal tax rate from increasing. I may be misundertstanding though! Thanks for your help!

        My recent post What are Your Options for Tax-Advantaged Retirement Savings and Investments?

    3. At first you got me really scared. As I was reading what you were doing it was like look at the mirror's reflection. Then you put me back to the right seat, as I am diversifying my investments across as many vehicles as possible ensuring structured withdrawals in the future. So I should be OK since I have 401k IRA but also taxable accounts to tap in case of need.
      My recent post Web feature – stock quotes ticker

      • Thanks for your comment Martin! But yeah, no reason to be really scared. It's just something to think about as you're deciding how much money to put where. Having money in retirement accounts is definitely a good thing, you just want to make sure you have a good amount of money that can be accessed without penalty if it is needed prior to age 59.5. Sounds like you're doing well though!

        Where do you have your taxable account? I have mine with Vanguard. They do a pretty good job!
        My recent post The Top Online Savings Accounts with the Best APY

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